Global Meltdown, Redux: Is it 2009, All Over Again?

Across China, Europe, and the United States, an alarming, synchronized slowdown is underway. The poisons from the Great Recession haven't worked their way out of the global economy.

Reuters

In the annals of world economic experience, 2009 was a terrible year. It was the first since 1945 in which global economic output contracted in aggregate.

Now, just three years later, we are on the verge of the same happening again. Data releases from around the world last week suggest an alarming, synchronized slowdown is underway. Another global recession so soon after the last one, at a time when an intractable debt crisis is tearing Europe apart while a divided United States is still reeling from the 2008-2009 financial meltdown, could easily undermine international trade relations and even threaten world peace.

This synchronicity is no accident. It is rooted in the problem of global economic imbalances, the same issue that had a heavy hand in the previous crisis. Simply put, this concept describes a world in which economies such as China's and Germany's run overly high savings ratings and depend on exports for growth while debtor nations such as the United States and those of peripheral Europe depend too much on consumption and imports. This imbalance created what Federal Reserve Chairman identified in 2005 as the "global savings glut," a giant, international pool of funds that fueled the debt bubbles of the pre-crisis era in the U.S. and Europe.

A MESS OF OUR OWN MAKING

These imbalances did not arise organically. They were encouraged by the United States' post-Cold War mania for financial deregulation, by Chinese social and monetary policies that forced people to save at punitively low interest rates and which set the exchange rate to exporters' advantage, and by European leaders' blindness to the risks of creating a monetary union without the equivalent political or fiscal unity. Together, this mix of misaligned policies gave rise to a highly liquid global financial system in which giant, multinational banks grew so large that they fueled fears of systemic collapse, leaving policymakers paralyzed by their "Too Big to Fail" status when the party ended.

After the crisis, governments paid lip service to correcting these imbalances. But other than a few token agreements at G20 summits, the opportunity for a re-balancing was squandered. In fact, what countries on either side of the imbalance did was to double down their bets on the old, flawed system.

China, faced with the sharp declines in its U.S. and European export markets and with the need to produce jobs for millions of annual new entrants into the labor force, fixed its exchange rate at an artificially weak level and unleashed even more of its financially repressed savers' money to fund an unprecedented construction boom. It built high-speed rail networks, office and housing towers, airports and other projects at a breakneck pace. Initially, this succeeded in rapidly restoring growth to the 10% levels China had become used to. But instead of re-balancing its economic model toward consumption-led growth, it made China dependent on an unstoppable treadmill of investment, a trend that perpetually raised the bar ever higher for the consumer-based society it planned to have in the future, whose spending would now have to rise even higher if all the empty apartments or bullet train seats were to be filled. In the end the speculative bubble scared Chinese authorities, as did an outbreak of inflation. So they eventually tightened monetary conditions by letting both the exchange rate and interest rates rise. This slowed the economy to the extent that the world is now worrying about a downturn in Chinese demand--especially foreign producers of the commodities with which China has fueled its construction boom.

China's balancing act wasn't helped by America's response to the crisis, either. The United States' inability to recover from the 2009 recession in the same way that it had rebounded from past recessions stemmed from both the giant overhang of debt left from the housing bubble and the abundance of cheap production options in China, which encouraged U.S. employers to try to recover lost profitability by shifting operations offshore in search of lower costs. It meant that Corporate America survived but also that more than 20 million Americans stayed unemployed or underemployed and that debt-laden households further curtailed the discretionary spending that's needed to drive America's consumption-dependent economy.

A backlash against perceived Washington excesses precluding the federal government from providing as much fiscal stimulus as the economy needed, which meant the baton passed to the U.S. Federal Reserve. Having exhausted all other options, the Fed pumped trillions of fresh dollars into the economy. But because the dollar is the world's primary reserve and commercial currency, this flood of money did little to help the U.S. economy because much of it simply escaped offshore in search of higher returns in commodity markets and Asian real estate. China was especially affected by this. With its currency pegged to the dollar, it meant that China effectively imported inflation from the U.S.

Europe took a different but equally damaging course. There, the imbalances were internal - Germany and other Northern nations saved and lent; Greece, Ireland, Portugal and Spain spent and borrowed. Once the savings glut-fueled bubble burst, the underlying lack of competitiveness in the peripheral nations, which underpinned the imbalances, was exposed. As private creditors fled these less competitive nations' debt markets, their governments turned to the Northerners for help. But Germany and co. would only provide aid on the strict condition that fiscal spending be drastically cut back, the results of which were the recent social meltdowns and voter rebellions in places like Greece.

The tensions have turned a breakup of the euro zone into a distinct possibility. If it comes to that it would be a global catastrophe. The international banking system that developed out of the pre-crisis global savings glut is too interconnected to withstand such an event without profound losses and extreme capital flight. But at least financial institutions have had time to prepare for Europe's crisis. What they are not ready for is for a euro breakdown to occur simultaneously with economic downturns in China and the U.S. Therein lies the great risk of a synchronized contraction, as highlighted by Friday's weak U.S. jobs report and Chinese manufacturing data.

WHAT DO WE DO NOW?

Having used up ammunition in the last go-round, governments have little fiscal or monetary firepower left. They should instead set aside their domestic agendas and engage in truly coordinated actions. To restore global investor confidence, they need to free up trade, coordinate fiscal and social policies that help rectify savings and spending imbalances, write enforceable rules requiring free-floating exchange rates and uniformly regulated financial sectors, and develop a centralized system for storing currency reserves so that the dollar loses its distorting dominance.

The trauma of the 1930s reminds us of the risks to world economic and political cohesion when nations respond to global problems with self-serving national solutions. We must resist that outcome. We must make global solution the top priority.